Band Aid on Humpty Dumpty

The volatility in stocks and bonds are off the hook.  130 point overnight range in SPX.  35 bps overnight range in 10 year yields.  They broke Humpty Dumpty and bandaids won't be enough to put it back together.  This haphazard bailout of depositors by providing par value loans on deep underwater hold to maturity (HTM) collateral is not going to placate the stock market for long.  Just out of the blue, Signature Bank was taken over by the FDIC without a warning on Sunday, just showing you how fragile the regional banks are.  They are loaded to the gills with underwater HTM collateral that no one wants except vulture hedge funds looking to pay 60 cents on the dollar.  And who's going to keep deposits at a crap regional bank collecting nearly zero interest when they can safely park their cash in money markets or T-bills at a brokerage firm and access cash same day via wire.  

The banks have a business model based on either dumb or lazy people who keep their money there collecting near zero interest when they could just buy a money market fund/ shorter term Treasury ETF through their stock broker.  These bank runs at regional banks should wake up a few of those lazy people into moving their funds to where they are better treated.

Backstopping the deposits prevents the bank runs, but it doesn't fix the root of the problem.  The banks are stuck with huge losses on their HTM collateral, and their deposits are moving out to places which offer much higher interest.  The banks either keeps rates low and let those deposits leave, or they substantially raise the interest on their deposits to keep the deposits that they do have, reducing profitability.  My bet is they try to wait it out, hoping this BTFP facility will keep their customers feeling safe, and hope that they are too dumb and lazy to move their cash to money markets or T-bills, to maintain their net interest margin.  

The broader economic implications of all this is tighter financial conditions, especially bank lending.  And with short term rates near 5%, there is little incentive for banks, especially regional banks to go out on the risk curve and lend in a slowing economy when they can just park their deposits in the RRP and earn the spread, which is huge because they are paying next to nothing on deposits.  And in case there is a bank run, they can quickly pay out without having to dip into their HTM pool and risk realizing losses for the whole portfolio and having to raise equity capital, which will be nearly impossible in this environment.  

The BTFP program is a small band aid put on the patient that is bleeding profusely from the shotgun wound that was buying long term MBS and Treasuries at ridiculously low yields when the Fed promised not to raise rates until 2024.  It was a combination of greed, incompetence, and belief in Fed forward guidance that has put these regional banks in a bind, hoping that their customers are blissfully unaware of the bank's precarious situation.  

The only lasting solution to the problem is rate cuts, and lots of them.  Fine tuning 50-100 bps will not get the job done.  The only way to get the whole yield curve lower to help out bank portfolios is to cut rates and signal more cuts in the future.  If Powell hikes in March and continues his hawk act, the stock market will revolt.  We could have a December 2018 scenario when Powell raised 25 bps to 2.5% and signaled automatic pilot for QT and didn't talk about a pause.  We know what happened after.  Stocks plunged for the next few days and Powell pivoted.  

This time, the economy is in a much worse spot as rates are double what they were in December 2018 with leading indicators much weaker.  Housing is weaker than 2018.  Global economy is weaker than 2018.  Inflation much higher.  If inflation doesn't come down as fast as the bond market is pricing, and the Fed still cuts, you may get huge steepening of the yield curve, like you saw in early to mid 2008, and not even get a move lower in long bond yields, which would not be good for mortgages or the banks' portfolios.  

So what is the Fed going to do here?  Will Powell think he stopped the bank runs and its all systems go on the fight against inflation with more 25 bps rate hikes?  As much as Powell wants to be the next Volcker, 2023 is not 1980.  The leverage built up in the system is much greater.  The US has become bailout nation as any little blowup is quickly defused with some random bazooka facility meant to keep Humpty Dumpty together.  In my view, Powell will fold like a cheap lawn chair.  His hawk act won't be taken well when you have banks blowing up.  Powell can resolve this either voluntarily (1) or involuntarily (2):  1)  Powell decides to cease and desist on his Volcker wannabe hiking campaign, and signals a pause, which will boost stocks for a few weeks and stanch the bleeding in the regional banks.   2)  Powell keeps the same message of higher for longer and the market forces his hand by plunging until he cries uncle.  

I am leaning towards 1) but either way, the market will get what it wants:  rate cuts. And these rate cuts will be warranted because the psychology around regional banks has completely changed, and now almost everyone is aware of how much duration risk these banks are carrying, along with deposit flight risk in a high interest rate environment.  Credit will get much tighter, lending standards will get stricter, and less money will flow to the economy.  This SIVB blowup has just kickstarted what was already a cycle that was going down, albeit slowly.  This has just sped things up and brought forward the recession timeline.  

Stocks are trading quite sanguine given the circumstances, with lighter hedge fund positioning in equities helping out here.  This reminds me of the end of the bull market in August 2007 when stocks were plunging as signs of stress in the banking system were percolating, and the Fed came in to cut the rate for the discount window, and followed up with a 50 bps rate cut in September.  The market embraced the Fed pivoting to rate cuts and rallied all the way from mid August to early October 2007.  

I can picture a similar situation when the Fed pivots and rallies on rate cut hopes.  But that rally probably lasts just a few weeks before investors realize they are buying right before a huge earnings recession in a fast slowing economy.  Historically, bear markets bottom after the Fed is well into its rate cutting cycle.  It could be different this time, as the markets are wiser in regards to how powerful Fed easing is towards financial markets.  But at these still rich equity market valuations, I lean towards history rhyming and market bottoming only after several rate cuts and a real capitulation in the stock market.   

We are in a different ballgame than 2022.  2022 was about inflation fears leading to rate shock fears.   2023 will be about credit tightening fears leading to recession fears.  The stock/bond correlation has flipped, and we're back to the same old negative correlation reflexive moves of stocks and bonds.  I expect that to be the case until you get a final big capitulation bottom in stocks.

Yesterday, we saw credit spreads blow out a bit, nothing crazy, but considering the sideways trading day in stocks, its a warning sign to be cautious trying to buy the dip here.  Also the MOVE index has hit a new high, above the 2020 Covid highs, so bond vol. is still in a raging bull market.  We have CPI today, and it seems the crowd is expecting another hot number.  But economic data is now a sideshow, so its not going to matter for long.  At current levels in SPX, not a compelling case for a buy or a sell.  I am a small buyer if we get one more flush lower below 3800.  I see a much better risk/reward buying Treasuries on any pullbacks.  The past few days have been an emphatic move that is signaling a bull curve steepening for the rest of the year.  

The Fed's power hiking cycle has finally broken something and that's usually when the Fed pivots.  If we do get a little bit more panic in the market, that could mark an intermediate term bottom IF Powell signals an end to rate hikes after March (even if he hikes 25 bps).  We could see a reflexive chase move higher on the Powell pivot and SPX could go towards 4200.  Which would be a great spot to put on long term shorts.  If Powell doesn't pivot next week, this market is not going to like it and it'll probably have to go much lower to get him to act.  In that case, we're going to see some savage moves.